Debt-Ridden Equilibria - A Simple Theory of Great Depressions -

Abstract

The US Great Depression and Japan's lost decade in the 1990s are both characterized as persistent stagnations of economies with debt-ridden corporate sectors subsequent to asset-price collapses. We propose a simple model, in which increases in corporate debt (and/or fluctuations in expectations about the future state of the economy) can account for these episodes. Key ingredients are the assumptions that firms are subject to collateral constraint on liquidity for financing the inputs, and that the firms can hold other firms' stocks as their assets and use them as the collateral. Collateral constraint on inputs interlinks the financial market inefficiency with the factor market inefficiencies; and that the corporate stocks are used as collateral generates an externality of self-reference in stock prices and production, that is, higher stock prices loosen the collateral constraint and lead to higher efficiencies in production, which in turn justify the higher stock prices. It is shown that there exists a continuum of steady-state equilibria indexed by the amount of debt that the firms owe to the consumers: A steady state with a larger debt can be called a debt-ridden equilibrium, since it has more inefficient factor markets, produces less output, and is characterized by lower stock prices. The model provides the policy implication that debt reduction in the corporate sector at the expense of consumers (or taxpayers) may be welfare-improving when the firms are debt-ridden.